By Kostya etus, CFA, Senior Portfolio Manager
One-year time periods are often annualized in performance reports. Annualized returns may seem small, but aggravated over a long period of time, they result in significant cumulative returns. As returns increase and the time period expands, small differences begin to have a more exponential impact. But it is important to note that yields do not normally rule out the impact of inflation. Inflation erodes your wealth behind the scenes and it will help you not to forget it.
The table below shows the long-term annualized returns as well as the 20-year accumulated returns of the major indices.
Annualized vs. cumulative
Investment returns for a given asset class are usually reported in annualized terms. For example, total U.S. markets have had approximately 6.5% annualized profitability over the past 20 years, which seems like a wrong figure. But that doesn’t mean your total return for the entire period is 130% (a 6.5% return multiplied by 20 years). The interest of composition is that you get returns not only from your initial investment, but also from the returns generated last year. This really starts to add up over time. Therefore, an annualized return of 6.5% actually equates to a return of 254.7% over a 20-year period (this means that you have tripled more of your money). This is the ultimate advantage of maintaining long-term investment.
Inflation: the silent killer
It may seem like the safest place to make money is under the mattress (or at least in a safe), but the truth is that you have to take some risk to avoid losing money. The reason: inflation, that is, the steady rise in prices for goods and services. For example, the average cost of a movie ticket in 1999 was $ 5.08; in 2018 it was $ 9.11.
In the last 20 years, aggregate annualized inflation has been 2% annually. But let’s not forget the composition, which means that 2% creates a cumulative price increase of more than 50%. Keeping the money in the bank would have earned you 1.7% annualized, or 39.8% accumulated, during that same time period. This is lower than the inflation rate, meaning you would have lost money simply by leaving it in the bank.
As annualized returns increase and the time period extends, even small differences can have a large impact on accumulated returns. For example, emerging markets (MS) returned 7.4% year-on-year, while US small businesses returned 9.0%. This represents an increase of just under 2% (remember that 2% inflation worsened by around 50%). But the cumulative returns are 313.9% for MS and 461.9% for small businesses. This is almost a 150% difference. Much higher than 50% inflation. Therefore, the next time you compare annualized returns, keep in mind that a small increase can have exponential advantages when compounded in the long run.
As Albert Einstein famously said: “Compound interest is the eighth wonder of the world. Whoever understands it, wins it … whoever doesn’t … pays it “.
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